Inflation is about to jump, but will the rise persist? - Capital Economics
Global Economics

Inflation is about to jump, but will the rise persist?

Global Inflation Watch
Written by Global Economics Team

Inflation will rise sharply in every major economy in the months ahead, driven by a rebound in energy inflation, tax changes, and supply shortages. On average, CPI inflation in the advanced economies looks set to rise from 1.1% in February to 2.6% in May. But while the increase will probably prove transitory in the euro-zone, we expect a higher rate of core inflation to persist in the US. The US recovery is already relatively advanced, and the economy is set to benefit from another round of fiscal stimulus. The labour market looks tighter than that in the euro-zone and there is firmer evidence of rising input costs being passed on to consumers. What’s more, the Fed has made a more decisive shift towards tolerating higher inflation than the ECB, which has served to boost inflation expectations further.

  • Table of Key Forecasts
  • Overview – Inflation will rise sharply in every major economy in the months ahead, driven by a rebound in energy inflation, tax changes, and supply shortages. On average, CPI inflation in the advanced economies looks set to rise from 1.1% in February to 2.6% in May. But while the increase will probably prove transitory in the euro-zone, we expect a higher rate of core inflation to persist in the US. (See Chart 1.) The US recovery is already relatively advanced, and the economy is set to benefit from another round of fiscal stimulus. The labour market looks tighter than that in the euro-zone and there is firmer evidence of rising input costs being passed on to consumers. What’s more, the Fed has made a more decisive shift towards tolerating higher inflation than the ECB, which has served to boost inflation expectations further.
  • Demand and Capacity – Supply shortages will boost inflation in most DMs over the next 3-6 months. But underlying demand weakness will see core inflation fall back in the euro-zone next year. (See page 5.)
  • Labour Markets – Persistent slack in the labour market will ensure that wage growth remains subdued on the whole. But the US labour market appears to be tighter than most. (See page 6.)
  • Commodity Prices – Higher oil prices will cause energy inflation to surge in the next few months, boosting headline rates significantly. But this effect will reverse in 2022. (See page 7.)
  • Monetary Conditions and Policy – The explosion of central bank balance sheets has led many to fear a policy-driven rise in inflation. But we doubt that this will happen in the near term at least. (See page 8.)
  • Inflation Expectations – Investors’ inflation expectations have risen sharply, particularly for the US, but they are still consistent with central banks’ targets. (See page 9.)
  • Emerging Markets – Energy effects will boost headline rates in the near term. But GDP in most EMs will struggle to get back to their pre-virus paths, so underlying inflation should stay subdued. (See page 10.)

Chart 1: US & Euro-zone Core CPI Inflation (%)

Sources: Refinitiv, Capital Economics


Forecast Summary

Table 1: Key Forecasts

Average

Forecasts

Year avg. unless o/w stated

2010-2016

2017

2018

2019

2020

2021

2022

Headline CPI Inflation

World (1)

3.4

3.0

3.1

2.8

2.5

3.1

2.4

Advanced economies

1.4

1.7

2.0

1.5

0.7

2.1

1.4

Emerging economies (1)

4.6

3.7

3.7

3.6

3.7

3.6

3.1

US

1.6

2.1

2.4

1.8

1.2

2.8

1.8

Euro-zone

1.3

1.5

1.8

1.2

0.3

2.1

1.0

Germany

1.3

1.7

1.9

1.4

0.4

2.8

1.2

France

1.8

2.3

2.2

1.3

0.5

2.2

1.0

Italy

1.3

1.3

1.2

0.6

-0.1

1.8

1.0

Japan

0.4

0.5

1.0

0.5

0.0

0.2

0.3

UK

2.2

2.7

2.5

1.8

0.9

1.5

1.5

Canada

1.7

1.6

2.3

1.9

0.7

2.3

1.7

China

2.8

1.6

2.1

2.9

2.5

1.5

1.5

India

8.2

3.3

4.0

3.7

6.6

5.3

4.3

Russia

8.2

3.7

2.9

4.5

3.4

5.3

4.3

Brazil

6.8

3.5

3.7

3.7

3.2

4.5

3.0

Core CPI Inflation

US

1.8

1.8

2.1

2.2

1.7

2.2

2.5

Euro-zone

1.1

1.0

1.0

1.0

0.7

1.5

1.1

Japan

0.2

0.2

0.3

0.6

0.2

0.1

0.3

UK

2.1

2.3

2.1

1.7

1.4

1.3

1.6

Real GDP

World (2)

3.7

3.8

3.4

2.6

-3.6

6.9

4.5

Advanced economies

1.8

2.4

2.2

1.6

-5.2

5.1

3.9

Emerging economies (2)

5.2

4.7

4.1

3.2

-2.6

7.9

4.9

US

2.2

2.2

2.9

2.3

-3.5

6.5

4.0

Euro-zone

1.1

2.4

1.9

1.2

-6.8

4.2

3.8

Japan

1.4

1.9

0.8

0.7

-4.9

3.7

2.5

UK

2.0

1.8

1.4

1.5

-9.9

5.2

7.2

Canada

2.1

3.0

2.0

1.6

-5.4

5.8

4.0

China (2)

6.7

5.8

5.4

5.5

1.0

10.0

3.5

India

7.7

6.9

7.4

5.3

-7.0

13.4

8.5

Russia

1.6

1.6

2.3

1.3

-3.5

3.5

3.3

Brazil

1.4

1.3

1.3

1.1

-4.1

3.0

2.0

Commodity Prices (3)

Latest

Oil (Brent $ pb)

40

67

54

66

52

70

60

Gold ($/oz)

1,956

1,302

1,283

1,517

1,898

1,600

1,550

(1) Excludes Venezuela & Argentina; (2) China estimates based on our China Activity Proxy; (3) End-year, not year average.


Overview

Supply shortages and energy effects to drive near-term pick-up…

  • Inflation will rise sharply in every major economy in the months ahead, driven by a rebound in energy inflation, tax changes, and supply shortages. But underlying price pressures appear stronger in the US than elsewhere and there has been a bigger shift in central bank thinking, meaning that inflation rates will diverge in 2022.
  • The key factor driving headline inflation rates over the coming months will be a rise in energy inflation. The recent increase in the brent crude oil price, coupled with our expectation of a further rise to $80pb in Q3, has led us to project that energy effects will add around 1.5 percentage points to average headline inflation in DMs in the next three months. (See Chart 2.)
  • At the same time, base effects and supply shortages are set to drive core rates higher. Prices of services including airfares slumped as the pandemic took hold and core inflation will rise mechanically on the anniversary of those declines. Moreover, supply shortages are driving up the price of key inputs including semiconductors, and shipping costs from Asia have surged. (See Chart 3.) Surveys suggest that the rise in input costs is being passed on to customers, albeit not in full. (See Chart 4.)
  • Beyond the next few months, price pressures will depend more heavily on underlying economic developments. Energy inflation is set to fall back, and supply shortages should ease as spending patterns normalise. For example, the recent surge in demand for household electronics is unlikely to be sustained. Our expectation is that US GDP will rise furthest above its pre-virus level compared to other major advanced economies by the end of 2022. (See Chart 5.) Australia and Canada will follow, while Spain and Italy will lag behind.

Chart 2: Brent Oil Price & Contribution of Energy Price Inflation to DM Headline CPI Inflation

Chart 3: Freightos Index of Shipping Costs
(% change since Jan. 2020)

Chart 4: Manufacturing PMI Price Indices

Chart 5: GDP in Q4 2022
(% Change from Pre-virus Level)

Sources: Refinitiv, IHS Markit, Capital Economics

Overview (continued)

…Greater inflation divergence in 2022 as US extends its lead

  • Other indicators also point to greater underlying price pressure in the US than elsewhere. Inventories are already relatively lean and the recent rise in “voluntary quits” implies that the labour market is much tighter than that in the euro-zone, for example. The related pick-up in wage growth, combined with additional fiscal stimulus, will see incomes growth far outstrip that in Europe. (See Chart 6.)
  • Monetary policy looks set to remain extremely loose across the board in DMs. The US Fed has signalled that it will tolerate higher inflation with a shift to an average inflation target. The Reserve Bank of Australia seems equally keen to drive inflation sustainably higher. But while the ECB is holding a policy review, like with the BoJ’s review in March, it is unlikely to make major changes. And in any case, inflation has been low for so long that it would be difficult to shift. Note that inflation expectations have risen much further in the US than the euro-zone.
  • On balance, we see inflation rising across the board in the rest of this year and then dipping back to below target as energy effects ease in 2022. (See Chart 7.) But there will be a marked divergence in core inflation rates, with the year’s pick-up set to persist in the US and UK, but to reverse relatively quickly in the euro-zone. Japanese core inflation will stay characteristically close to zero. (See Chart 8.)
  • In the Emerging Markets, energy effects will drive inflation up alongside that in DMs in the months ahead, but this will be partly offset by a fall in food inflation as supply problems ease. Core inflation will generally remain subdued, but there will be some pick-up in China given the advanced stage of the economic recovery. Currency declines point to higher inflation in Russia, Turkey, and Brazil. (See Chart 9.)

Chart 6: Nominal Household Dispoable Incomes
(% y/y)

Chart 7: Headline CPI Inflation in Selected Major Advanced Economies (%)

Chart 8: Core CPI Inflation in Selected Major Advanced Economies (%)

Chart 9: Headline CPI Inflation by EM Region (%)

Sources: Refinitiv, CEIC, Capital Economics


Demand and Capacity

Outside the US, this year’s rise in core inflation is likely to be temporary

  • Throughout DMs, the disinflationary forces of the pandemic are easing as recoveries take hold, with supply constraints adding to inflation pressures. But in 2022, euro-zone core inflation should drop back, due to a more persistent shortfall in demand from its pre-virus path.
  • There is growing evidence that shortages of certain goods, as well as rising shipping costs, are pushing up manufacturers’ costs. The input price indices of the manufacturing PMIs have surged to almost record highs in most DMs. While firms have begun to pass on higher costs, we expect the impact on inflation to be limited.
  • Output gaps have become less meaningful gauges of spare capacity since virus restrictions, rather than demand weakness, are largely responsible for shortfalls in GDP. But, at least according to surveys, industrial firms judged they were still operating below capacity at the end of last year, which should limit inflation pressures for now. (See Chart 10.)
  • That said, underlying inflation is likely to be highest in the US among major DMs. While inventories of consumer goods have begun to recover relative to sales in the US, they remain lean by past standards. In contrast, the sales-to-stocks ratio in the euro-zone is high and rising. (See Chart 11.) This suggests that shortages will play a smaller role in driving up core inflation in the euro-zone than in the US.
  • Further ahead, our forecasts suggest that DM GDP will still be below its pre-virus path by the end of 2022, implying that core inflation will generally be subdued. (See Chart 12.) Once again, the key exception is the US, where the $1.9tn fiscal stimulus looks set to turbo-charge the recovery. Indeed, in contrast to other DMs, we expect GDP in the US to return to its pre-virus path by the end of 2022. (See Chart 13.)

Chart 10: OECD Survey of Industrial Capacity Utilisation (Std. Deviations From LR Average)

Chart 11: Retail Stocks-to-Sales Ratios

Chart 12: Advanced Economy GDP (Int’l$tn)

Chart 13: End-2022 GDP Forecasts Compared to
Pre-Virus Path (%)

Sources: Refinitiv, Capital Economics


Labour Markets

Labour market slack to keep inflation pressures at bay

  • Vaccine rollouts and relaxation of restrictions should pave the way for a rebound in hours worked. However, hidden slack in the labour market is likely to take some years to erode completely. Earnings growth will accelerate in most advanced economies, particularly the US, but this shouldn’t lead to a rise in core inflation that will trouble central banks.
  • Headline figures on employment and unemployment are difficult to compare across countries due to the different approaches taken to limit the financial impact of the crisis on households. But one point is clear – the big remaining shortfall in hours worked suggests that there is still considerable scope for employment to recover. (See Chart 14.)
  • Admittedly, we expect most of this shortfall to be reversed later this year. Indeed, the fact that a disproportionate share of the deficit in hours worked is skewed towards sectors that are most vulnerable to virus restrictions, suggests that labour markets will recover quite rapidly once restrictions are removed. (See Chart 15.)
  • But it will take longer than the next year or two to get to a stage where labour markets are tight enough to stoke a pick-up in underlying earnings growth. Surveys suggest that the labour market is already tightest in the US, so we expect pay growth to accelerate most there. (See Chart 16.)
  • Even in the US, though, we only expect higher pay growth to keep core inflation above 2%, rather than driving it higher. Once all the various COVID-related data distortions wash out, we suspect that earnings growth will not be high enough to squeeze firms’ margins and tempt them to pass on higher costs to consumers. Indeed, our DM unit labour cost forecasts are consistent with core inflation settling around its pre-virus level by the end-2022. (See Chart 17.)

Chart 14: % Shortfalls in Labour Force, Employment & Hours Worked (Q4 2020 vs. Q4 2019)

Chart 15: US & UK Breakdown of Shortfalls in Hours Worked One Year on from Peak Employment (%-pts)

Chart 16: Survey Measures of Firms’ Difficulty in Finding Workers (Std Dev. from LR Average, 3m avg.)

Chart 17: DM Unit Labour Costs & Core Inflation

Sources: Refinitiv, Capital Economics


Commodity Prices

Higher oil prices will be the principal driver of headline inflation in 2021

  • While the prices of most commodities have enjoyed a strong rally since the initial news about effective vaccines in November, it will be mainly higher oil prices that push up headline inflation in most economies this year. However, this boost to inflation should dissipate in 2022.
  • With vaccine rollouts paving the way for restrictions on activity and domestic travel to be relaxed this year, the demand prospects for crude oil have looked positive for some months now. But given the uncertainty around this outlook, at its March meeting OPEC+ opted to restrict oil output this year by more than we and others had anticipated. With financial pressures likely to keep US shale supply constrained this year too, we have raised our end-2021 and end-2022 Brent oil price forecasts to $70pb and $60pb, from $60pb and $55pb previously.
  • Our forecasts imply that energy inflation will drive up headline rates in DMs by an additional 1.5%-pts on average in the next three months. (See Chart 18.) Given that fuel is an important input in other industries, there may be some second-round effects of higher oil prices on core rates of inflation. But history suggests any such effects will be small. (See Chart 19.)
  • Agricultural commodity prices have soared in the past six months, but we don’t expect them to feed through to higher DM inflation. For one thing, we expect them to drop back this year as supply catches up with demand. What’s more, consumer food prices spiked last year, so strong base effects mean that food inflation should drag on headline rates this year. (See Chart 20.)
  • Finally, while the surge in industrial metals prices (see Chart 21) has received attention, it is unlikely to have much impact on inflation. Indeed, metal inputs into goods and services amount to just 1-2% of consumption in DMs.

Chart 18: Brent Oil Price & Contribution of Energy Price Inflation to DM Headline CPI Inflation

Chart 19: Average Response of Inflation in Advanced Economies to a 100% y/y Oil Price Shock (%-pts)

Chart 20: Agricultural Commodity Prices & Contrib. of Food Price Inflation to DM Headline CPI Inflation

Chart 21: S&P GSCI Industrial Metals (1 Jan 21 = 100)

Sources: Refinitiv, Capital Economics


Monetary Conditions and Policy

Inflation risk from policy stimulus small over our two-year forecast horizon

  • The explosion of central bank balance sheets has led many to fear a policy-driven rise in inflation. (See Chart 22.) But we doubt that this will happen in the near term at least. Whether it does so further ahead depends mostly on changing attitudes towards higher inflation.
  • Broad measures of the money supply continued to rise at a rapid pace in Q4. (See Chart 23.) But bank lending growth has eased, particularly in the US. (See Chart 24.) There are few signs that central banks will dial down policy support, especially in the face of the recent rout in the bond market. The Fed and the BoE have reiterated that policy will be kept ultra-loose for a long time yet. And the ECB said that it would step up the pace of its purchases to loosen financial conditions in the months ahead.
  • We doubt that the rapid rise in the money supply will generate higher inflation at least over the next two years. Bank lending surveys suggest that the tightening of credit criteria seen at the height of the pandemic in the US and euro-zone has not since been reversed. (See Chart 25.) And we do not expect households or firms to run down the savings that they built up during lockdowns. Even if they do dip into their savings, we suspect there is spare capacity to absorb some additional demand. And the money may be used to pay down debt, rather than being spent on goods and services. This is what the US private sector has done recently.
  • With the vaccine rollout set to inject new life into the global recovery in the second half of 2020, stronger demand could fuel inflation further ahead. Central banks have the tools to nip any rise in the bud. The main risk therefore is that an institutional slide towards accepting higher inflation means that policymakers act too late, a risk that appears highest in the US.

Chart 22: Central Bank Balance Sheets (% of GDP)

Chart 23: M3 Money (% y/y)

Chart 24: Bank Lending to Non-Financial Firms*
(% y/y)

Chart 25: Bank Business Credit Standards
(Net % Balance)

Sources: Refinitiv, Capital Economics


Inflation Expectations

Increases in inflation expectations not a worry for central banks

  • Since our last Inflation Watch, market measures of inflation expectations have risen, and some business survey measures have followed suit. The big picture, however, hasn’t changed – inflation is expected to stay low for many years.
  • The 5y/5y US breakeven inflation rate has rebounded from its nadir a year ago to levels last seen in late 2018. But according to a Fed staff model, most of this recovery has reflected term premia rather than pure expectations for higher future inflation. It was only in the past three months – as the new US administration’s fiscal bill made its way through Congress – that estimates of investors’ genuine long-term inflation expectations picked up. While the recovery has been rapid, the level of expected inflation remains subdued and consistent with the 2% average inflation target. (See Chart 26.)
  • In the past couple of weeks, long-term inflation swap rates have taken a leg up in the euro-zone too. (See Chart 27.) Admittedly, much of the euro-zone still far behind the US in the economic recovery, and there no big additional fiscal support in the pipeline. But vaccine hopes appear to have eased investors’ fears that euro-zone inflation will get stuck at rock-bottom levels in the longer run.
  • While businesses are reporting that they are facing mounting costs in the likes of the PMI surveys, other surveys suggest that they do not envisage passing much of these onto consumers. Firms’ expectations for raising selling prices have risen in a few cases, particularly in industries that are exposed to goods shortages and higher shipping costs. But they have not risen to high levels by past standards. (See Chart 28.) Even so, given the favourable base effects at work, there is a consensus among economists that inflation is about to rebound. (See Chart 29.)

Chart 26: 5Y/5Y Forward US Treasury Breakeven Inflation & Investor Inflation Expectations Model (%)

Chart 27: US & Euro-zone 5Y/5Y Inflation Swaps (%)

Chart 28: Firms’ Selling Price Expectations 3-6m Ahead (Std. deviations from 2005-2021 average)

Chart 29: Economist Consensus & CE Inflation Forecasts for Advanced Economies (%)

Sources: Refinitiv, DKW (2019), Bloomberg, Capital Economics


Emerging Markets

Policymakers will generally look through rising headline inflation

  • As in advanced economies, the disinflationary effects that dominated in 2020 have begun to reverse in Emerging Markets. (See Chart 30.) EM inflation rose in February and we expect it to keep rising, largely due to a jump in fuel inflation. Central banks in Russia, Brazil, and Turkey have hiked rates in response. But with core inflation in most EMs low by past standards, policymakers are more likely to look through the rise elsewhere.
  • This year, the jump in fuel inflation (see Chart 31) looks set to add an average of around
    0.8%-pts to EM headline rates. That’s slightly less than in DMs, in part because energy carries a smaller weight in EM CPI baskets. It’s also because the sharp fall in many EM currencies last year, and subsequent recovery, has acted to dampen the impact of swings in USD oil prices.
  • Outside China, food inflation has generally risen in recent months. (See Chart 32.) The outlook is more mixed. In China, we expect it to rise as pork inflation normalises post swine flu. But in places where supply disruptions have caused sharp price gains, such as Russia and Brazil, food inflation should start to ease.
  • Further ahead, we anticipate that headline inflation rates will generally drop back as energy inflation recedes. After all, in most EMs, by the end of the year GDP will still be some distance below the path which we anticipated before the pandemic. (See Chart 33.)
  • There are some key exceptions. In China and Taiwan, the stronger economic recovery will put some upward pressure on underlying inflation. Elsewhere, the risks of higher core inflation are probably greatest in some economies in Central and Eastern Europe.

Chart 30: Aggregate EM Inflation (%)

Chart 31: EM Fuel Prices & Brent Crude Prices
(% y/y)

Chart 32: EM Food Inflation (%)

Chart 33: Latest GDP Forecasts Compared to Pre-Virus Path (End-2021)

Sources: Refinitiv, Capital Economics


Jennifer McKeown, Head of Global Economics Service, jennifer.mckeown@capitaleconomics.com
Simon MacAdam, Senior Global Economist, simon.macadam@capitaleconomics.com
Gabriella Dickens, Global Economist, gabriella.dickens@capitaleconomics.com